Saturday, July 24, 2010

Every discipline develops its own dogma and finance is no exception; we make assumptions about how markets are structured and investor behavior that underlie much of our theory. Those within the discipline either take these fundamental assumptions as given or are reluctant to question them. Over the last few months, I have been working on a new book titled "What if?", where I am looking at how financial theory and practice would change, if the bedrock assumptions of finance were violated or no longer true. I just finished my first installment, where I look at how investment practice and corporate finance would change if there is nothing that is guaranteed or risk free. You can get the paper by going to:http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1648164

In an earlier post, I examined the mechanics of how best to estimate the risk free rate when there is no default free entity. Through most of that post, I focused on emerging markets, where governments are often prone to default, but left untouched the basic presumption that developed market governments like the United States, UK and Germany are default free. But that presumption has been put to the test by the banking crisis of 2008 and the Greek default drama of 2010.

I start by looking at how the presence of a risk free investment changes the way in which we construct portfolios and make corporate finance decisions. In particular, the presence of a risk free investment allows for separation between risk preferences and portfolio composition. Thus, two investors with different degrees of risk aversion can end up holding the same portfolio of risky assets and adjust for risk, by altering the proportions of their wealth that they put into the risk free asset. In corporate finance, the presence of a risk free investment can alter investment, financing and dividend policy.

So, what makes for a risk free investment? The issuing entity has to have no default risk, which restricts us to government securities, because governments alone have the power to print currency. The catch, though, is that governments sometimes default. While the explanation for default is simple, when governments borrow in foreign currencies, it is more complex when governments borrow in their own currency. The trade off that leads to domestic currency default - the debasement of the currency that comes with printing more currency versus the pain of default - has resulted in governments defaulting on local currency borrowings. If the probability of such default exists, even if slight, government bond rates are no longer risk free.

The most common and widely used measures of government default are sovereign ratings from S&P, Moody's and Fitch. While ratings and default rates are highly correlated over time, suggesting that ratings agencies do a good job, on average, there is also evidence that ratings changes are lagging indicators. An alternative measure of sovereign default risk comes from the Credit Default Swap (CDS) market, where investors can buy or sell insurance against default by governments. CDS prices tend to update faster than sovereign ratings, but come with more volatility.

The absence of a risk free investment can have significant effects on both portfolio management and corporate finance. When investors lack a safe haven, they will become more risk averse and charge higher prices for risk. Higher prices for risk will translate into lower prices for all risky investments; we should expect to see stock prices and corporate bond prices decline. When firms have no risk free investments, lenders to these firms will be more wary about lending to them (leading to lower debt ratios) and investors may be less inclined to allow companies to accumulate cash (since that cash will be invested in risky assets).